As is true for anyone running for president – or any high-profile position, for that matter – your past words can come back to haunt you.
The first “culprit” Bloomberg identified, was the effort by legislatures to end redlining, the discriminatory practice of banks and other financial institutions to either refuse business or charge higher rates to individuals in communities with certain demographics.
In practice, redlining meant that Mr. Smith, in a mostly white neighborhood, would get a home loan at a market interest rate, whereas Mr. Jones, who lived in a predominantly black neighborhood and had the same economic profile as Mr. Smith, would be refused the loan or charged a much higher interest rate.
Bloomberg stated that the origins of the financial crisis “…all started back when there was a lot of pressure on banks to make loans to everyone. Redlining, if you remember, was the term where banks took whole neighborhoods and said, ‘People in these neighborhoods are poor, they’re not going to be able to pay off their mortgages, tell your salesmen don’t go into those areas.’”
According to Bloomberg, the end of redlining meant that banks were now forced by public policy to give loans to less creditworthy individuals. In response to all these new loans coming into the system, Wall Street created new investment products and “got themselves into a position where they owned a bunch of things they didn’t understand.”
Alas! If only those managers had been smart enough to know that reaping massive profits from selling highly risky investments without disclosing the risk to their customers was not a good thing to do, everything would have been different! I hate that when that happens.
It is interesting, to say the least, that the leader of a financial media empire thought that the end of redlining and a lack of sophistication by Wall Street company managers were pivotal in creating the financial crisis.
But the purpose of this article is not to point out the flaws of one person; it is to recall what Winston Churchill famously said, ‘Those who fail to learn from history are condemned to repeat it.”
A quick history lesson
So, as a reminder, here is a very short history.
The Community Reinvestment Act (CRA) of 1977 and the 1989 Financial Institutions Reform Recovery and Enforcement Act (FIRREA), were both passed almost two decades before the housing bubble.
Both acts sought to end redlining by mandating that bank lending records be audited for discrimination.
Neither of these acts required banks to make subprime loans or lower their lending standards. Based on both the timing of when these laws were passed and the effect of these laws, we can state with certainty that curtailing the practice of redlining did not create or even contribute to the housing bubble or financial crisis.
Contemporaneous to the housing bubble, on the other hand, was the emergence of the Collateralized Debt Obligations (CDOs) market.
Starting in the early 2000s, financial service organizations (i.e. Wall Street) began relying heavily upon the sales of CDOs based on subprime mortgages, to generate their profits.
Contrary to Bloomberg’s notion that the girth of subprime loans drove the expansion of the CDO market, the highly profitable CDO market drove the demand for mortgages, by the financial institutions to create more CDOs and make more money.
More to the point, the credit expansion that facilitated speculation buying and cash-out refinancing, ultimately contributing to higher home prices, was not driven by the demand for housing. Rather, it was driven by the demand for subprime loans to feed the hungry, hungry hippo that was the CDO market.
To broaden the pool of potential customers, exotic loans like the option ARM and 100% financing became the norm rather than the exception.
Bloomberg’s questionable analysis gets one thing right: The decline of mortgage underwriting standards allowed for widespread speculation and drove up home prices to unsustainable levels.
Even if we don’t agree about the antecedents to the housing bubble, it is not up for debate that the weakening of lending standards in the early 2000s was the eye of the economic storm that devastated this country.
Learning from the past
Rather than dwell on the political narratives that both parties lay on each other for the housing bubble, I want to focus on how we can make sure this never happens again.
In the past decade, America, with proper regulation, has done a fabulous job of lending to those with sufficient cash flow and savings to own the debt of a mortgage.
Compared to the period between 2003 and 2008, loan profiles of mortgage originations in this record-breaking expansion have been excellent, as depicted by the shrinking number of low credit score loans. (See below)
With proper lending standards, we don’t allow debt speculation from investors or even higher FICO score-quality clients who would need an exotic structure mortgage to obtain a loan.
The debt expansion in this cycle looks exactly right to me because the debt structure is normal and we are lending to the capacity to own the debt.
This is why keeping qualified mortgage rules is a must in America. We can always find ways to make any regulation better but the core thesis of lending to those that have the capacity to own the debt should not be touched.
Additionally, back in 2002-2005, the housing price boom was on and a few people wanted to cash in on it, real home price growth took off from 2002-2005 as well as cash-out loans.
Now, real home prices (see below) don’t look like anything we saw during the few really hot years of the housing bubble and neither does cash out lending.
Even with the nested equity in place, we don’t see the cash-out volumes like we saw back during the housing bubble years
In order for the housing market to become a tool to create short-term wealth, rather than a means to provide shelter and stable neighborhoods, it requires facilitation from a variety of sources.
A slackening of lending standards by banks, exotic debt structures to support speculation, and changes in SEC capital leverage laws from 10-1 to 40-1, as occurred in 2004, were some of the facilitators that contributed to our housing bubble and crash.
With proper lending standards in place, we can prevent the repeat of the excessive debt expansion and cash-out borrowing of the early 2000s, while still allowing qualified borrowers to purchase.
Since 2008, all you need in America to buy a home is a 620 FICO score, a 3.5% downpayment, plus the closing cost, and a 43% debt to income ratio. In any coherent world, these standards can’t be considered tight lending.
If lending was too tight, would purchase applications be at cycle highs and 2020 year over year growth at double digits for the past 4 weeks?
The housing market doesn’t need exotic loans or loosening standards. We have done a great job of making the home debt cycle safe and this stability has contributed to the longest economic and job expansion ever in U.S. history.
Let’s not ruin a good thing!